The Impact of the Sub-prime Financial Crisis on Stock Index Returns for High and Low Risk Countries

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This study uses a VAR framework developed by Longstaff (2008) to survey the contagion effects, impulse response and variance decomposition from the ABX index represented by the prices of the securitized CDOs of subprime mortgages to the CDS index in North America (referred to as the CDX-US index in this study) represented by credit risk and liquidity risk, and from the CDX-US index to stock indices in high-risk and low-risk countries during the pre-crisis and crisis periods. The empirical findings indicate that there are contagion effects between the CDO and CDS markets in the initial stage of the crisis, and that there is a major increase in the degree of impulse response and the ratio of variance decomposition from the ABX index to the CDX-US index in the outburst stage. In the VAR model, the impulse response, variance decomposition and contagion effects from the lower-rated ABX index to the CDX-US indices is larger than those from the higher-rated ABX index to the CDX-US indices. The results of the causation test show that the CDX-US index spreads separately to stock markets in high-risk and low-risk countries, which conforms to the view that CDS markets lead stock markets as addressed by Norden and Weber (2004). In the outburst stage, there is a larger degree of impulse response and components of the variance from the CDX-US indices to the stock indices in high-risk countries than in low-risk countries. In the initial stage of the crisis, there are significant contagion effects between the CDX-US indices and stock markets where there are more significant contagion effects from the CDX-US indices to stock indices in high-risk countries than in low-risk countries. Financial contagion spreads from stock markets in high-risk countries to those in low-risk ones. These results conform to the view that there is a major increase in shocks caused by financial crises in high-risk countries as described by Sach-Radelet (1998) and Kaminsky (2003). Therefore, on the one hand, the financial authorities in various countries may enhance the management of lower-rated CDOs through adequate financial policies. On the other hand, the public authorities in high-risk countries may reduce shocks from the CDS market in North America to their stock markets during the crisis period through economic measures aimed at reducing country risk.